New tax laws challenge the conventional wisdom about where to invest retirement savings.
When it comes to Uncle Sam’s cut of your nest egg, you can pay now or later. Even recent tax legislation hasn’t altered that. What have changed are the tradeoffs of holding particular kinds of assets in tax-deferred and taxable accounts.
It used to be that tax-deferred retirement accounts–401(k)s, IRAs and the like–were the place for stocks, particularly those paying dividends. Before the law changed last year, dividends were taxed as ordinary income at a rate as high as 38.6%. The same rate applied to profits on stocks held less than one year, while long-term capital gains were taxed at 20%. So it made sense to postpone those levies until retirement, when you’d probably be in a lower tax bracket. These days, though, it may be better to hold stocks in a taxable account. The 2003 tax law reduced through 2008 the top rate on dividends and long-term gains to 15%–a break you’ll lose on retirement-plan assets that are ultimately taxed at income tax rates, which tend to be higher.
Under the new rules, you may want to reserve retirement accounts for such assets as governement bonds, which generate interest that is taxed at ordinary income tax rates. High-yield bond funds, with their relatively high taxable payouts, are another good candidate, as are real estate investment trusts, the dividends from which usually don’t qualify for the new 15% rate. Similarly, stock funds that tend to turn over holdings frequently could be candidates for tax deferral, because they generate short-term gains that are taxed as ordinary income.